MONTGOMERY FUNDS III
N-30D, 1998-02-23
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<PAGE>
 
                          Montgomery Variable Series:
                                  Growth Fund

                                 Annual Report
                               December 31, 1997

                     [LOGO OF MONTGOMERY VARIABLE SERIES:]
                               Invest wisely.(R)
                             The Montgomery Funds
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Highlights
December 31, 1997
- --------------------------------------------------------------------------------
Investment Review

Q:  How did the Fund perform for the six months and full year ended December 31,
    1997? 

A:  The Montgomery Variable Series: Growth Fund was up 10.47% for the second
    half of 1997 and finished the full year with a 28.57% return. Although this
    performance represented strong absolute results, it returned less than the
    S&P 500. Our focus on buying stocks of companies that we believe have the
    best forward potential at the most reasonable prices has us positioned in
    companies that are smaller, faster growing and less expensive than those in
    the S&P 500. Even so, they went relatively unrewarded last year. So too did
    the shares of companies sensitive to economic growth, which may represent
    the most overlooked and underappreciated area of the current stock market.

Q:  Before we get into specifics about the portfolio, what are your thoughts on
    the U.S. and world economies going into 1998?

A:  As we enter 1998 and in spite of the uncertainty created, we are still
    waiting for the impact of Asia's financial crisis to show up in U.S.
    economic data. Gross Domestic Product ("GDP") for 1997 grew at a robust 3.9%
    rate, and that was the fastest growth since the current expansion began
    almost eight years ago. Inflation has continued to ease, and the Federal
    Reserve has moved to a more balanced view of economic risk. Most of the
    troubled countries in the Asia Pacific region have begun to make progress
    toward restructuring their debt. It is likely, however, that the economies
    in this region will be in retrenchment throughout 1998. There is also
    evidence that the financial paralysis that has gripped Japan may be in the
    process of important improvement with recent changes at the Ministry of
    Finance. The behavior of China remains a wildcard, but most observers
    believe that China will not devalue its currency this year. In the United
    States, the financial markets are watching to determine if the growing lack
    of presidential credibility will spill over into domestic and, more
    important, international policy.

     At this point, most economists expect 1998 U.S. GDP growth to be in the 2.5
     to 3.0% range, coupled with inflation expectations (as measured by the
     Consumer Price Index) of less than 2%. World growth expectations likewise
     remain optimistic, with any slowdown in the Asia Pacific region being
     offset by stronger growth out of Europe.

                             [GRAPH APPEARS HERE]

Portfolio Management
- --------------------------------------------------------------------------------
Roger W. Honour......................................  Senior Portfolio Manager
Andrew Pratt.........................................  Portfolio Manager
Kathryn M. Peters....................................  Portfolio Manager
- --------------------------------------------------------------------------------
Fund Performance
- --------------------------------------------------------------------------------
Average annual total returns for the
periods ended 12/31/97
- --------------------------------------------------------------------------------
<TABLE> 
<CAPTION> 
                          Montgomery Variable Series:
                                  Growth Fund
<S>                                                                   <C> 
Since inception (2/9/96)............................................  29.72%
One Year............................................................  28.57%

                                 S&P 500 Index
Since 1/31/96.......................................................  27.19%
One Year............................................................  33.35%
</TABLE> 
- --------------------------------------------------------------------------------
Past performance is no guarantee of future results. Net asset value, investment
return and principal value will fluctuate so that shares, when redeemed, may be
worth more or less than their original cost.
- --------------------------------------------------------------------------------
1  The Standard & Poor's 500 Index is composed of 500 widely held common stocks
   listed on the NYSE, AMEX, and OTC market.

2  The Lipper Growth Funds Average universe consists of 658 funds.

                                                                               1
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Highlights (continued)
December 31, 1997


Q:  How do these economic growth estimates affect S&P 500 earnings expectations
    and your outlook for the stock market this year?

A:  Most top-down forecasters are looking for 1998 to be the seventh consecutive
    year of S&P 500 earnings growth. Expectations are for growth of 6% in
    earnings this year, a slowdown from the 10% gains in 1997. The stock market
    is already selling at a historically high price/earnings multiple of almost
    21 times those expected earnings. Also, operating margins are nearing peak
    of cycle levels, thus making it more difficult for companies to leverage
    revenue growth into faster earnings growth. We believe, therefore, that 1998
    will be a more difficult year in terms of stock market returns, especially
    when compared with the robust gains of the past three years.

Q:  What effect does that have on how the Montgomery Growth Fund is positioned
    for the coming year?

A:  As discussed above, if you owned "the market" as represented by the S&P 500,
    you would be paying about 21 times expected earnings to capture only 6%
    expected growth. By contrast, the Montgomery Growth Fund is currently paying
    18 times expected 1998 earnings to capture expected growth of 24%. In other
    words, we are potentially buying four times the growth of the overall stock
    market but at a more reasonable valuation. To do this we are buying some
    smaller companies that we believe have much better profiles for forward
    growth, yet trade at lower multiples of their growth rates. Also, as
    mentioned earlier, we believe that some of the cycle-sensitive areas of the
    market represent good value, and many of these companies are undergoing
    substantial restructuring and efficiency realignment programs, with the
    expected result of improved shareholder returns.

Q:  Would that explain the portfolio's overweighting in the pulp and paper
    products sector?

A:  Yes. This is an example of a group that is both extremely inexpensive by
    today's stock market valuations and is, at the same time, generally
    undergoing significant cost containment and business rationalization moves
    to improve future profitability. Non-core and non-productive assets are
    being sold off, repositioned or shut down. Capital structures are being made
    more efficient, new revenue growth objectives are being initiated, asset
    utilization is being improved and management's and directors' incentives are
    being aligned with those of shareholders through required stock ownership.
    Plant capacity additions in the next two years should be well below recent
    memory and well below expected demand growth. At the same time, the stocks
    recently hit 30-year relative price lows. We believe that once the
    uncertainties surrounding the impact of the slowdown in Asian economies
    subside, the group offers good return potential. The group is underowned and
    out of favor on Wall Street despite what appears to be solid efforts by
    management toward long-term fundamental change. The companies we own in this
    group include Champion International Corporation, Chesapeake Corporation,
    International Paper Company and Boise Cascade.

2
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Highlights (continued)
December 31, 1997

Q:  For newer shareholders would you briefly discuss your investment process?

A:  We use proprietary, quantitative screening techniques as a tool to identify
    positive, long-term fundamental change in a company's or industry's business
    and its expected earnings. We then conduct fundamental analysis to determine
    the validity and sustainability of the change. Finally, we apply our
    valuation criteria to determine the future potential for the share price. We
    attempt to build portfolios of good companies that meet our fundamental
    criteria and where the valuation allows our shareholders to benefit from
    future appreciation.


                              Top Five Industries
                        (as a percentage of net assets)

- --------------------------------------------------------------------------------
<TABLE> 
<S>                                                                   <C>
     Pulp and Paper...............................................    8.1%
     Software Systems.............................................     6.8
     Retail Trade.................................................     6.1
     Banks/Savings and Loan.......................................     5.6
     Telecommunications Equipment.................................     4.7
</TABLE>
- --------------------------------------------------------------------------------



                               Top Ten Holdings
                        (as a percentage of net assets)
- ------------------------------------------------------------------------------- 
<TABLE> 
<S>                                                                  <C>
     Golden West Financial Corporation............................    3.9%
     Avid Technology Inc..........................................    3.8
     Nordstrom, Inc...............................................    3.8
     Interstate Hotels Company....................................    2.9
     Canadian National Railway Company............................    2.6
     International Paper Company..................................    2.5
     United Stationers, Inc.......................................    2.3
     Sybase, Inc..................................................    2.3
     Ericsson (L.M.) Telephone Company, Class B, ADR..............    2.1
     Amerada Hess Corporation.....................................    2.1
- --------------------------------------------------------------------------------
</TABLE>
                                                                               3
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Investments
December 31, 1997

<TABLE> 
<CAPTION> 

Common Stocks-81.1%                                                                              Value  
     Shares                                                                                     (Note 1)
<S>                      <C>                                                                    <C>      
                         Airlines-1.1%                                                                   
     2,250               Federal Express Corporation+                                          $  137,391
                                                                                               ---------- 
                         Apparel and Textiles-0.7%                                                       
     2,050               VF Corporation                                                            94,300
                                                                                               ----------
                         Auto/Auto Parts-2.9%                                                            
     4,250               General Motors Corporation                                               257,655
     2,100               PACCAR, Inc.                                                             110,381
                                                                                               ---------- 
                                                                                                  368,036
                                                                                               ---------- 
                         Banks/Savings and Loan-5.6%                                                     
     1,500               BankAmerica Corporation                                                  109,500
     875                 Citicorp                                                                 110,633
     5,000               Golden West Financial Corporation                                        489,062
                                                                                               ----------
                                                                                                  709,195
                                                                                               ---------- 
                         Building Materials-2.6%                                                         
     5,125               Masco Corporation                                                        260,734
     4,500               RPM of Ohio, Inc.                                                         69,469
                                                                                               ---------- 
                                                                                                  330,203
                                                                                               ---------- 
                         Business Services-2.7%                                                          
     2,500               AccuStaff Inc.+                                                           57,500
     3,844               Cendant Corporation+                                                     132,137
     1,750               Computer Sciences Corporation +                                          144,484
                                                                                               ---------- 
                                                                                                  334,121
                                                                                               ---------- 
                         Chemicals-2.1%                                                                  
     1,550               Dow Chemical Company                                                     157,325
     1,800               Eastman Chemical Company                                                 107,213
                                                                                               ---------- 
                                                                                                  264,538
                                                                                               ---------- 
                         Computers and Office Equipment-1.2%                                             
     8,500               Data General Corporation+                                                148,219
                                                                                               ----------
                         Conglomerates-2.4%                                                              
     4,100               Canadian Pacific, Ltd.                                                   111,725
     4,300               Tyco International Ltd.                                                  193,769
                                                                                               ---------- 
                                                                                                  305,494
                                                                                               ---------- 
                         Diversified Financial Services-1.3%                                             
     4,300               FirstPlus Financial Group+                                               164,744
                                                                                               ----------
                         Electrical Equipment-1.0%                                                       
     800                 Matsushita Electric Industrial Company, Ltd., ADR                        121,600
                                                                                               ----------
                         Electronics-1.4%                                                                
     4,050               Raychem Corporation                                                      174,403 
                                                                                               ---------- 
</TABLE>
  The accompanying notes are an integral part of these financial statements.

4
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Investments (continued)
December 31, 1997
<TABLE> 
<CAPTION> 
Common Stocks (continued)                                                                         Value
     Shares                                                                                      (Note 1)
<S>                            <C>                                                               <C>     
                               Food and Beverage-1.3%                                                    
     12,650                    Fleming Companies, Inc.                                           $169,984
                                                                                               ---------- 
                               Health Care-0.3%                                                          
     800                       Healthcare COMPARE Corporation+                                     40,900
                                                                                               ---------- 
                               Home Appliance-1.0%                                                       
     2,200                     Whirlpool Corporation                                              121,000
                                                                                               ---------- 
                               Household Products-1.2%                                                   
     2,400                     Unilever N.V., ADR                                                 149,850
                                                                                               ---------- 
                               Insurance-0.6%                                                            
     1,100                     Life Re Corporation                                                 71,706
                                                                                               ---------- 
                               Lodging-2.9%                                                              
     10,300                    Interstate Hotels Company+                                         361,144
                                                                                               ---------- 
                               Machinery and Tools-0.7%                                                  
     2,750                     Manitowoc Company, Inc.                                             89,375
                                                                                               ---------- 
                               Metals and Mining-2.3%                                                    
     1,700                     Aluminum Company of America (Alcoa)                                119,637
     4,600                     Brush Wellman Inc.                                                 112,700
     3,700                     Freeport-McMoRan Copper and Gold, Inc., Series B                    58,275
                                                                                               ---------- 
                                                                                                  290,612
                                                                                               ---------- 
                               Newspapers/Publishing-2.9%                                                
     3,350                     Donnelley (R.R.) & Sons Company                                    124,787
     1,950                     Time Warner, Inc.                                                  120,900
     4,700                     World Color Press, Inc.+                                           124,844
                                                                                               ---------- 
                                                                                                  370,531
                                                                                               ---------- 
                               Oil-4.4%                                                                  
     4,800                     Amerada Hess Corporation                                           263,400
     3,925                     Belco Oil & Gas Corporation+                                        73,839
     8,950                     Union Pacific Resources Group, Inc.                                217,038
                                                                                               ---------- 
                                                                                                  554,277
                                                                                               ---------- 
                               Oilfield Equipment-4.0%                                                   
     5,800                     Dril-Quip, Inc.+                                                   203,725
     2,500                     Schlumberger Ltd.                                                  201,250
     1,700                     Tidewater Inc.                                                      93,713
                                                                                               ---------- 
                                                                                                  498,688 
                                                                                               ---------- 
                               Pipelines-0.5%                                                            
     1,500                     Enron Corporation                                                   62,344 
                                                                                               ---------- 
</TABLE>
  The accompanying notes are an integral part of these financial statements.

                                                                               5
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Investments (continued)
December 31, 1997

<TABLE> 
<CAPTION> 
Common Stocks (continued)                                                                            Value
Shares                                                                                               (Note 1)
<C>                            <S>                                                               <C>
                               Pulp and Paper-8.1%
       7,400                   Boise Cascade Corporation                                          $   223,850
       2,300                   Champion International Corporation                                     104,219
       2,900                   Chesapeake Corporation                                                  99,506
       7,200                   International Paper Company                                            310,500
       6,000                   United Stationers, Inc.+                                               288,375
                                                                                                   ---------- 
                                                                                                    1,026,450
                                                                                                   ----------  
                               Railroad-3.8%                                                                 
       6,800                   Canadian National Railway Company                                      321,300
       2,450                   Union Pacific Corporation                                              152,972
                                                                                                   ----------  
                                                                                                      474,272 
                                                                                                   ----------  
                               Real Estate Investment Trust-1.5%                                             
       5,196                   Meditrust Companies                                                    190,953

                                                                                                   ----------  
                               Retail Trade-6.1%                                                             
       2,675                   Dayton Hudson Corporation                                              180,562
       7,900                   Nordstrom, Inc.                                                        475,975
       3,200                   TJX Companies, Inc.                                                    110,000
                                                                                                   ----------  
                                                                                                      766,537
                                                                                                   ----------  
                               Semiconductors-1.0%                                                           
       2,166                   Analog Devices Inc.+                                                    59,971
       1,600                   Texas Instruments, Inc.                                                 72,000
                                                                                                   ----------  
                                                                                                      131,971
                                                                                                   ----------  
                               Software Systems-6.8%                                                         
      18,000                   Avid Technology Inc.+                                                  482,625
       7,500                   Indus International, Inc.+                                              53,438
       1,300                   Structural Dynamics Research Corporation+                               29,413
      21,600                   Sybase, Inc.+                                                          288,225
                                                                                                   ----------  
                                                                                                      853,701
                                                                                                   ----------  
                               Telecommunications-0.7%                                                       
       1,200                   China Telecom (Hong Kong) Ltd., Sponsored ADR+                          40,275
       1,250                   Newbridge Networks Corporation+                                         43,594
                                                                                                   ----------  
                                                                                                       83,869 
                                                                                                   ----------  
                               Telecommunications Equipment-4.7%                                             
       7,800                   Aspect Telecommunications Corporation+                                 163,800
       6,400                   Boston Technology Inc.+                                                160,800
       7,200                   Ericsson (L.M.) Telephone Company, Class B, ADR                        268,875
                                                                                                   ----------  
                                                                                                      593,475      
                                                                                                   ----------  
                               Trucking-1.3%                                                                 
       5,100                   Swift Transportation Company, Inc.+                                    166,069
                                                                                                   ----------  
                               Total Common Stocks (Cost $9,255,352)                               10,219,952 
                                                                                                   ==========
</TABLE>
  The accompanying notes are an integral part of these financial statements. 

6
<PAGE>
 
Montgomery Variable Series: Growth Fund
Portfolio Investments (continued)
December 31, 1997

<TABLE> 
<CAPTION> 
Repurchase Agreements-20.7%                                                                                             Value
Principal Amount                                                                                                       (Note 1)
<S>                              <C>                                                                                  <C> 
     $1,305,500                  Agreement with Bear Stearns, Tri-Party, 6.850% dated 12/31/97,
                                 to be repurchased at $1,305,997, on 01/02/98,
                                 collateralized by $1,359,876 market value of U.S. government
                                 securities, having various maturities and various interest rates.                     $ 1,305,500
     1,305,500                   Agreement with United Bank of Switzerland, Tri-Party, 6.900% dated 12/31/97,
                                 to be repurchased at $1,306,000, on 01/02/98, collateralized by $1,331,631
                                 market value of U.S. government securities, having various maturities and
                                 various interest rates                                                                  1,305,500
                                                                                                                       -----------
                                 Total Repurchase Agreements (Cost $2,611,000)                                           2,611,000 

Total Investments (Cost $11,866,352*)                                                      101.8%                       12,830,952

Other Assets and Liabilities (Net)                                                          (1.8)                         (233,573)

                                                                                           ------                      -----------
Net Assets                                                                                 100.0%                      $12,597,379
                                                                                           ======                      ===========
</TABLE> 
- -----------------------------
*  Aggregate cost for federal tax purposes was $11,908,596.
+  Non-income producing security.

Abbreviation:
ADR  American Depositary Receipt

  The accompanying notes are an integral part of these financial statements.  
                                                                               7
<PAGE>
 
Montgomery Variable Series: Growth Fund
Statement of Assets and Liabilities
December 31, 1997

<TABLE>
<S>                                                                        <C>                     <C>
Assets:
Investments in securities, at value (Identified cost $11,866,352) (Note 1)
     Securities.................................................                                    $ 10,219,952
     Repurchase agreements......................................                                       2,611,000
                                                                                                    ------------
     Total investments..........................................                                      12,830,952
Cash............................................................                                           1,934
Receivables:
     Shares of beneficial interest sold.........................                                          83,858
     Investment securities sold.................................                                          19,141
     Dividends..................................................                                           9,473
     Interest...................................................                                             499
Other Assets:
     Organization costs (Note 1)................................                                          39,636
                                                                                                    ------------
Total Assets....................................................                                      12,985,493

Liabilities:
Payables:
     Investment securities purchased............................   $   350,905
     Legal and audit fees.......................................        21,500
     Management fee (Note 2)....................................         7,877
     Trustees' fees and expenses (Note 2).......................         1,323
     Shares of beneficial interest redeemed.....................           718
     Other accrued liabilities and expenses.....................         5,791
                                                                   -----------
Total Liabilities...............................................                                         388,114
                                                                                                    ------------
Net Assets......................................................                                    $ 12,597,379
                                                                                                    ============
Net Assets consist of:
Undistributed net investment income.............................                                    $      1,035
Accumulated net realized gain on securities sold................                                           2,380
Net unrealized appreciation of investments......................                                         964,600
Shares of beneficial interest...................................                                           8,349
Additional paid-in capital......................................                                      11,621,015
                                                                                                    ------------
Net Assets......................................................                                    $ 12,597,379
                                                                                                    ============
Net Asset Value, offering and redemption price per share
($12,597,379-834,878 shares of beneficial interest outstanding).                                    $     15.09
                                                                                                    ===========
</TABLE>
  The accompanying notes are an integral part of these financial statements.

8
<PAGE>
 
Montgomery Variable Series: Growth Fund
Statement of Operations
For the Year Ended December 31, 1997
<TABLE> 
<S>                                                                             <C>                          <C>
Investment Income:
Interest.........................................................................                             $    91,168
Dividends (Net of foreign withholding taxes of $966).............................                                  57,957
                                                                                                              -----------
Total Investment Income..........................................................                                 149,125

Expenses:
Management fee (Note 2).......................................................... $    71,499
Legal and audit fees.............................................................      23,003
Printing fees....................................................................      19,863
Amortization of organization expenses (Note 1)...................................      12,389
Custodian fees...................................................................       5,932
Trustees' fees and expenses (Note 2).............................................       5,084
Other............................................................................       2,651
Interest expense.................................................................         438
                                                                                  ------------
Total Expenses...................................................................                                 140,859
Fees deferred and expenses absorbed by Manager (Note 2)..........................                                (116,101)
                                                                                                              ------------
Net Expenses.....................................................................                                   24,758
                                                                                                              ------------
Net Investment Income............................................................                                  124,367
                                                                                                              ------------
Net Realized and Unrealized Gain on Investments (Notes 1 and 3):
Net realized gain on investments during the year.................................                                 431,903
Net unrealized appreciation of investments during the year.......................                                 825,450
                                                                                                              -----------
Net Realized and Unrealized Gain on Investments..................................                               1,257,353
                                                                                                              -----------
Net Increase in Net Assets Resulting from Operations.............................                             $ 1,381,720
                                                                                                              -----------
</TABLE>

<TABLE>
<CAPTION>
      
Statement of Changes in Net Assets
                                                                                For the Year Ended        For the Period Ended
Net Increase in Net Assets Resulting from Operations:                                12/31/97                   12/31/96*
                                                                                  ------------                ----------- 
<S>                                                                              <C>                         <C> 
Net investment income............................................................ $   124,367                 $   26,607
Net realized gain on investments during the period...............................     431,903                     74,537
Net unrealized appreciation of investments during the period.....................     825,450                    139,150
                                                                                  ------------                -----------
Net increase in net assets resulting from operations.............................   1,381,720                    240,294
                                                                                                    
Distributions to Shareholders:                                                                      
Distributions from net investment income.........................................    (123,377)                  (26,562)
Distributions from net realized gains on investments.............................    (443,288)                  (60,772)
                                                                                                    
Beneficial Interest Transactions:                                                                   
Net increase from beneficial interest transactions (Note 4)......................   9,655,629                  1,854,346
                                                                                  ------------                -----------
Net increase in net assets.......................................................  10,470,684                  2,007,306
                                                                                                    
Net Assets:                                                                                         
Beginning of period..............................................................   2,126,695                    119,389
                                                                                  ------------                -----------
End of period.................................................................... $12,597,379                 $2,126,695
                                                                                  ------------                -----------
Undistributed net investment income.............................................. $     1,035                         --
                                                                                  ============                ===========
</TABLE>
- ------------------------------------
*  Montgomery Variable Series: Growth Fund commenced operations on February 9,
   1996.

  The accompanying notes are an integral part of these financial statements.

                                                                               9
<PAGE>
 
Montgomery Variable Series: Growth Fund
Financial Highlights
Selected Per Share Data for the Year or Period Ended:

<TABLE>
<CAPTION>
                                                                         12/31/97                                  12/31/96*
<S>                                                                     <C>                                        <C>
Net asset value--beginning of period................................    $ 12.33                                    $ 10.08
                                                                        -------                                    -------
Net investment income...............................................       0.16                                       0.15
Net realized and unrealized gain on investments.....................       3.35                                       2.59
                                                                        -------                                    -------
Net increase in net assets resulting from investment operations.....       3.51                                       2.74
Distributions to Shareholders:
     Distributions from net investment income.......................      (0.16)                                     (0.15)
     Distributions from net realized gains on investments...........      (0.59)                                     (0.34)
                                                                        -------                                    -------
     Total Distributions............................................      (0.75)                                     (0.49)
                                                                        -------                                    -------
Net asset value--end of period......................................    $ 15.09                                    $ 12.33
                                                                        =======                                    =======
Total return**......................................................      28.57%                                     27.22%
                                                                        =======                                    =======
Ratios to Average Net Assets/Supplemental Data:
Net assets, end of period (in 000's)................................    $12,597                                    $ 2,127
Ratio of net investment income to average net assets................       1.74%                                      2.55%+
Ratio of operating expenses to average net assets, including
     interest expense...............................................       0.35%                                      0.01%+
Ratio of operating expenses to average net assets, excluding
   interest expense.................................................       0.34%                                       --
Portfolio turnover rate.............................................         53%                                       78%
Average commission rate paid (a)....................................    $0.0586                                   $0.0520
Net investment income/(loss) before  deferral of fees and
     absorption of expenses by Manager..............................    $  0.01                                   $ (0.27)
Operating expense ratio before deferral of fees and absorption
     of expenses by Manager, including interest expense.............       1.97%                                     6.98%+
</TABLE>
- --------------------------------
*    Montgomery Variable Series: Growth Fund commenced operations on February 9,
     1996
**   Total return represents aggregate total return for the periods indicated.
+    Annualized.
(a)  Average commission rate paid per share of securities purchased and sold by
     the Fund.

  The accompanying notes are an integral part of these financial statements.

10
<PAGE>
 
The Montgomery Funds III
Notes to Financial Statements

The Montgomery Funds III (the "Trust") is registered under the Investment
Company Act of 1940, as amended (the "1940 Act"), as a diversified, open-end
management investment company and was organized as a Delaware business trust on
August 24, 1994. As of December 31, 1997, the Trust had four series, the
Montgomery Variable Series: Growth Fund, the Montgomery Variable Series:
Emerging Markets Fund, the Montgomery Variable Series: International Small Cap
Fund and the Montgomery Variable Series: Small Cap Opportunities Fund. The
Montgomery Variable Series: Small Cap Opportunities Fund had not commenced
operations as of December 31, 1997. Prior to the public offerings of shares of
the Funds, a limited number of shares were sold to Montgomery Asset Management,
LLC (or its predecessor) and/or affiliated persons of Montgomery Asset
Management in private placement offerings. Otherwise, the Funds had no
significant operations prior to February 2, 1996, the date on which the
Montgomery Variable Series: Emerging Markets Fund commenced operations (i.e.,
commenced selling shares to the public). Information presented in these
financial statements pertains to the Montgomery Variable Series: Growth Fund
(the "Fund"). The Montgomery Variable Series: Emerging Markets Fund and the
Montgomery Variable Series: International Small Cap Fund are presented under
separate covers.

1.  Significant Accounting Policies:

The preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts and disclosures in the financial statements. Actual
results could differ from those estimates. The following is a summary of
significant accounting policies.

a.  Portfolio Valuation

     The Fund's securities are valued using current market valuations: either
the last reported sales price or, lacking any reported sales, and in the case of
fixed income securities, the mean between the closing bid and asked prices.
Securities for which market quotations are not readily available (including
restricted securities which are subject to limitations as to their sale) are
valued at fair value by management as determined in good faith by or under the
supervision of the Trust in accordance with methods which are authorized by the
Trust's Board of Trustees.

     Short term debt obligations with remaining maturities in excess of 60 days
are valued at current market prices, as discussed above. Short-term securities
with maturities of 60 days or less are carried at amortized cost, which
approximates market value.

b.  Dividends and Distributions

     Dividends from net investment income, if any, are declared and paid at
least annually. Distributions of net realized capital gains (including net
short-term capital gains) are distributed no less frequently than annually.
Additional distributions of net investment income and capital gains for the Fund
may be made in order to avoid the application of a 4% non-deductible excise tax
on certain undistributed amounts of ordinary income and capital gains. Income
distributions and capital gain distributions are determined in accordance with
income tax regulations which may differ from generally accepted accounting
principles. These differences are primarily due to differing treatments of
income and gains on various investment securities held by the Fund, timing
differences and differing characterizations of distributions made by the Fund.

c.  Repurchase Agreements

     The Fund may engage in repurchase agreement transactions individually or
jointly through a joint repurchase account with other series of the Trust and
affiliated registered investment companies pursuant to a joint repurchase
agreement. Under the terms of a typical repurchase agreement, the Fund takes
possession of a government debt obligation as collateral. The Fund also agrees
with the counterparty to allow the counterparty to repurchase, and the Fund to
resell the obligation at a specified date and price, thereby determining the
yield during the Fund's holding period. This arrangement results in a fixed rate
of return that is not subject to market fluctuations during the Fund's holding
period. The value of the collateral is at least equal at all times to the total
amount of the repurchase obligations, including interest. In the event of
counterparty default, the Fund has the right to use the collateral to offset
losses incurred. There could be potential loss to the Fund in the event the Fund
is delayed or prevented from exercising its rights to dispose of the collateral
securities, including the risk of a possible decline in the value of the
underlying securities during the period while the Fund seeks to assert its
rights. The Fund's investment manager, acting under the supervision of the Board
of Trustees, reviews the value of the collateral and the creditworthiness of
those banks and dealers with which the Fund enters into repurchase agreements to
evaluate potential risks. The Fund may also participate on an individual or
joint basis in tri-party repurchase agreements which involve a counterparty and
a custodian bank.

                                                                              11
<PAGE>
 
The Montgomery Funds III
Notes to Financial Statements
(continued)

    d.  Securities Transactions and Investment Income

        Securities transactions are recorded on a trade-date basis. Realized
        gain and loss from securities transactions are computed on the specific
        identified cost basis of the securities sold. Dividend income is
        recognized on the ex-dividend date and interest income, including,
        amortization of discount on short-term investments, is recognized on an
        accrual basis.

    e.  Federal Income Taxes

        The Fund has elected and qualified and it is the intention of the Fund
        to continue to qualify as a regulated investment company under
        Subchapter M of the Internal Revenue Code of 1986, as amended (the
        "Code"), by complying with the applicable requirements of the Code, and
        by making distributions of taxable income to shareholders sufficient to
        relieve the Fund from all or substantially all federal income taxes.
        Accordingly, no provision for federal income taxes is required.

    f.  Organization Costs

        Expenses incurred in connection with the organization of the Fund
        amounted to $62,066 and are amortized on a straight-line basis over a
        period of sixty months from commencement of operations.

    g.  Expenses

        General expenses of the Trust are allocated to the Fund based upon
        relative net assets. Operating expenses directly attributable to the
        Fund are charged to the Fund's operations.

2.  Management Fees and Other Transactions with Affiliates:

    a.  Montgomery Asset Management, LLC is the Fund's Manager (the "Manager").
        The Manager, a Delaware limited liability company, is an investment
        adviser registered with the Securities and Exchange Commission under the
        Investment Advisers Act of 1940, as amended (the "Advisers Act"). The
        Manager is a subsidiary of Commerzbank AG, one of the largest publicly
        held commercial banks in Germany.

        Pursuant to the investment management agreement ("Investment Management
        Agreement"), the Manager provides the Fund with advice on buying and
        selling securities, manages the investments of the Fund including the
        placement of orders for portfolio transactions, furnishes the Fund with
        office space and certain administrative services, and provides the
        personnel needed by the Trust with respect to the Manager's
        responsibilities under such Agreement. As compensation, the Fund pays
        the Manager a monthly management fee (accrued daily) at the following
        annual rates based upon the average daily net assets of the Fund:

              First $500 Million     Next $500 Million     Over $1 Billion
              ------------------     -----------------     ---------------
                    1.00%                 0.90%                0.80%

        The Manager has agreed to reduce some or all of its management fee or
        absorb the Fund expenses if necessary to keep the Fund's annual
        operating expenses, exclusive of interest or taxes, at or below 1.25% of
        the average daily net assets of the Fund. Any reductions or absorptions
        made for the Fund by the Manager of its fees are subject to recovery
        within the following three years provided the Fund is able to affect
        such reimbursement and remain in compliance with applicable expense
        limitations. 

        For the year ended December 31, 1997, the Manager has deferred fees of
        $71,499 and absorbed expenses of $44,602.

        As of December 31, 1997, the deferred management fees and absorbed
        expenses subject to recoupment are $188,928.

    b.  Certain officers and Trustees of the Trust are, with respect to the
        Trust's Managers, "affiliated persons" as defined in the 1940 Act. Each
        Trustee who is not an "affiliated person" receives an annual retainer
        and quarterly meeting fees totalling $35,000 per annum, as well as
        reimbursement for expenses, for services as a Trustee of all three
        Trusts advised by the Manager ($5,000 of which will be allocated to the
        Montgomery Funds III). 

        MAM Securities LLC, ("MAM Securities") serves as the Fund's transfer
        agent.

    c.  For the year ended December 31, 1997, the Fund incurred total brokerage
        commissions of $13,147.

3.  Securities Transactions:

    a.  The aggregate amount of purchases and sales of investment securities,
        other than short-term securities, for the year ended December 31, 1997,
        were $10,143,456 and $2,949,622, respectively.

    b.  At December 31, 1997, aggregate gross unrealized appreciation for all
        securities in which there was an excess of value over tax cost and
        aggregate gross unrealized depreciation for all securities in which
        there was an excess of tax cost over value for federal income tax
        purposes were $1,328,439 and $406,083, respectively.

12
<PAGE>
 
The Montgomery Funds III
Notes to Financial Statements
(continued)

    c.  Under an unsecured Revolving Credit Agreement with DeutscheBank (New
        York), the Montgomery Variable Series: Growth Fund, along with other
        funds of The Montgomery Funds I, The Montgomery Funds II and The
        Montgomery Funds III, may for one year starting August 6, 1997, borrow
        (consistent with applicable law and its investment policies) up to 10%
        of its net asset value, provided that the aggregate principal amount of
        outstanding loans under the agreement to all Funds does not exceed
        $300,000,000. The Fund pays its pro-rata share of the .08% quarterly
        commitment fee of the unutilized credit line balance. For the year ended
        December 31, 1997, there was no borrowing under this agreement.

4.  Transactions in Shares of Beneficial Interest:

    The Trust has authorized an unlimited number of shares of beneficial
    interest which have a par value of $0.01. Transactions in shares of
    beneficial interest for the periods indicated below were:
<TABLE>
<CAPTION>
                                                        Year Ended                                         Period Ended
                                                      December 31, 1997                                  December 31, 1996*
                                              Shares                     Amount                   Shares                   Amount
<S>                                        <C>                       <C>                        <C>                     <C>
     Shares Sold                             1,117,506                $15,968,560                 333,351               $ 3,946,116
     Issued as Reinvestment
      of Dividends                              38,314                    566,665                   7,141                    87,335
     Shares Redeemed                          (493,401)                (6,879,596)               (179,876)               (2,179,105)
                                             ---------                -----------                --------               -----------
     Net Increase                              662,419                $ 9,655,629                 160,616               $ 1,854,346
                                             =========                ===========                ========               ===========
</TABLE> 
- ----------------------
*   Montgomery Variable Series: Growth Fund commenced operations on February 9,
    1996 with initial funding of $119,389 and 11,843 shares.

5.  Change of Control of Manager:
    On March 25, 1997, Montgomery Securities, the Manager and CAM Acquisition
    LLC ("CAM"), a newly organized subsidiary of Commerzbank Aktiengesellschaft,
    entered into an agreement providing for the transfer of substantially all
    the assets comprising the Manager's business to CAM. On June 23, 1997, the
    shareholders of the Fund approved a new Investment Management Agreement with
    CAM (renamed Montgomery Asset Management, LLC) that became effective upon
    the closing of the Manager's transaction with CAM. Such transaction closed
    July 31, 1997.

                                                                              13
<PAGE>
 
Report of Independent Accountants
To the Trustees and Shareholders of the Montgomery Variable Series: Growth Fund


In our opinion, the accompanying statement of assets and liabilities, including
the portfolio investments, and the related statement of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of Montgomery Variable Series: Growth
Fund (one of the portfolios constituting the Montgomery Funds III, and hereafter
referred to as the "Fund") at December 31, 1997, and the results of its
operations, the changes in its net assets and the financial highlights for 
the year then ended, in conformity with generally accepted accounting
principles. These financial statements and financial highlights (hereafter
referred to as "financial statements") are the responsibility of the Fund's
management; our responsibility is to express an opinion on these financial
statements based on our audit. We conducted our audit of these statements in
accordance with generally accepted auditing standards which require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit, which included confirmation of investments at
December 31, 1997 by correspondence with the custodian and brokers, and the
application of alternative auditing procedures where confirmations from brokers
were not received, provides a reasonable basis for the opinion expressed above.

The financial statements of Montgomery Variable Series: Growth Fund for the
period from February 9, 1996 (commencement of operations) through December 31,
1996 were audited by other independent accountants whose report dated January
31, 1997 expressed an unqualified opinion on those statements.

Price Waterhouse LLP
San Francisco, CA
February 11, 1998

14
<PAGE>
 
The Montgomery Funds III
Note: Results of Voting at Special Shareholders' Meeting (Unaudited)

A special meeting of the Fund's shareholders was held on June 23, 1997. The
results of votes taken among shareholders on proposals before them are listed
below (may not total 100% because of rounding):

Proposal 1

     For the approval of the new Investment Management Agreement between the
     Fund and CAM Acquisition, LLC ("New Montgomery") pursuant to which New
     Montgomery will act as adviser with respect to the assets of the Fund, to
     become effective upon the closing of the transaction by which substantially
     all the assets of Montgomery Asset Management, L.P. will be acquired by New
     Montgomery, as subsidiary of Commerzbank AG.
<TABLE>
<CAPTION>
              Voting Result    # of Shares Voted   % of Shares Voted
             <S>                  <C>                 <C>
              For                   286,241.760              87.831%
              Against                39,612.359              12.155
              Abstained                  45.559               0.014
              Total                 325,899.678             100.000%
</TABLE> 
Proposal 2

     For the approval of authority for the Board of Trustees to approve any
future conversion of the Fund to a feeder fund in a master/feeder fund
structure.
<TABLE>
<CAPTION>
             Voting Result        # of Shares Voted   % of Shares Voted
             <S>                  <C>                 <C>
              For                   290,598.130              89.168%
              Against                35,255.989              10.818
              Abstained                  45.559               0.014
              Total                 325,899.678             100.000%
</TABLE> 

Proposal 3

     For the approval of certain changes to the fundamental investment
restrictions of the Fund, as described in the proxy statement.
<TABLE>
<CAPTION>
             Voting Result       # of Shares Voted   % of Shares Voted
             <S>                 <C>                 <C>
              For                  294,819.570              90.463%
              Against               31,034.549               9.523
              Abstained                 45.559               0.014
              Total                325,899.678             100.000%
</TABLE>
                                                                              15
<PAGE>
 
Tax Information (Unaudited)
Fiscal Year Ended December 31, 1997


The amounts of long-term capital gains paid for the fiscal year ended
December 31, 1997, were as follows:

     Montgomery Variable Series: Growth Fund..............    $58,152

Of the distribution made by the Fund, the corresponding percentage
represents the amount of the distribution which will qualify for the
dividends received deduction available to corporate shareholders:

     Montgomery Variable Series: Growth Fund..............    10.80%

16


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